Emerging Asia, Japan ETFs And The Correlation Myth

As Japanese Prime Minister Shinzo Abe and Bank of Japan Governor Haruhiko Kuroda have moved to employ an ultra-loose monetary policy that would make even Federal Reserve Chairman Ben Bernanke blush, chatter has increased that Japan's easing efforts will fuel a bubble in emerging markets.

The fear is that the some of the capital that is leaving Japan must find its way to emerging markets as Japanese investors search for higher returns.

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From there, speculation has intensified that emerging markets will "overheat" causing a bubble that inevitably burst. Emerging Asian nations make for logical destinations for Japanese investors and that would appear to validate bubble concerns...if some of these equity markets actually had intimate correlations to Japanese stocks.

When considering the evidence, arguably what is overheated is the talk about an emerging markets bubble at the hands of Japan's loose monetary policy. At least when it comes to select developing markets in Asia.

Consider this: Most mathematicians would agree that two variables are "very highly correlated" when the correlation ranges from 0.9 to 1. A range of 0.7 to 0.9 would be considered "highly correlated" while 0.5 to 0.7 would imply a moderate correlation. Drop below 0.5 and correlations can be considered low.

And that is basically what the correlations are over the past six months for Indonesia, Philippine and Thai equities to their Japanese counterparts: Low. The six-month time frame is relevant for several reasons. First, it was just over six months that Abe announced his candidacy for prime minister. Second, the time period includes Abe's victory and Kuroda's nomination and approval as the new BOJ governor. Bottom line: There have been plenty of catalysts since November 2012 to explain why the yen has been among the worst-performing developed market currencies since then.

Start with the Market Vectors Indonesia ETF (NYSE:IDX). In what has been a rough year for the largest emerging markets ETFs, such as those that track the BRIC nations, IDX has impressed with a gain of 10.5 percent.

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Over the past six months, IDX has an average correlation of just 0.35 to the iShares MSCI Japan Index Fund (NYSE:EWJ) and the WisdomTree Japan Hedged Equity Fund (NYSE:DXJ).To be fair, the UN lists Japan as Indonesia's third-largest trading partner. That may imply some level of bubble potential for Indonesian equity and ETFs as Japans wages war on its own currency. However, the reality is domestic demand, not exports is is the primary driver of Indonesian GDP.

Thailand could be a potential bubble in waiting because Japan is the country's second-largest trading partner behind the U.S. Thailand actually has a trade deficit with Japan. The rising baht/falling yen scenario could stoke bubble concerns as well.

Still, Thai equities, at least as measured by the iShares MSCI Thailand Capped Investable Market Index Fund (NYSE:THD), are not intimately correlated to Japanese stocks. THD's correlation to DXJ and EWJ over the past six months is 0.42.

The continued ascent by the iShares MSCI Philippines Investable Market Index Fund (NYSE:EPHE) and Philippine stocks has also fueled some bubble talk. The Philippine Stock Exchange Index jumped above the 7,100 level for the first time Monday and stocks there have been in rally mode since late 2011, long enough to warrant bubble talk in the eyes of some.

Then again, there are significant issues with saying EPHE and its holdings are bubbles waiting to burst. For example, the Philippines has consistently delivered the goods in terms of economic growth in the past year. While the largest emerging markets such as China and Brazil have disappointed regarding GDP growth, the Philippines has consistently surprised to the upside.

The Philippines finally land an investment-grade credit rating in late March. Critics may say that will only hasten inflows to the market, elevating bubble concerns in the process. Time will tell if that prediction proves accurate, but the reality is EPHE and Philippine stocks were surging well before the yen started falling and Abe was elected.